Section 16600 and Ixchel: benefit or burden?

California courts have long wrestled with how to strike an appropriate balance between free and unfettered competition, on the one hand, and contractual arrangements that protect and promote certainty, predictability and innovation in business relations, on the other. On Monday, the California Supreme Court endeavored to resolve these competing concerns in its much-anticipated decision on the issue in Ixchel Pharma, LLC, v. Biogen, Inc., 2020 DJDAR 8084.

The case arose out of last summer's decision by the 9th U.S. Circuit Court of Appeals in which the court certified two purportedly open -- and critical -- questions of state law to the California Supreme Court to resolve: first, whether Section 16600 of the California Business and Professions Code voids contracts in which a business is restrained from engaging in a lawful trade or business with another business; and second, whether a plaintiff is required to plead an "independently wrongful act" in order to state a claim for intentional interference with at-will contracts outside of the employment context.

The California Supreme ruled, first, while Section 16600 does apply to restraints on trade in business-to-business agreements, they are only invalid if they fail the so-called "rule of reason test"; and second, like an intentional interference with economic relations claim, a plaintiff must plead an "independently wrongful act" in order to allege a claim for intentional interference with an at-will contract, regardless whether the contract was one pertaining to employment or not. The Supreme Court's decision will have sweeping consequences with respect to the manner in which California companies (and companies opting to be governed by California law) conduct themselves, organize their business relationships, and compete with one another.

Background

In January 2016, Ixchel Pharma entered into a "Collaboration Agreement" with Forward Pharma related to the development of a new dimethyl fumarate drug to treat rare neurological diseases. That agreement set forth the parties' rights and responsibilities relating to the development of the drug, the conducting of clinical trials, the assessment of the drug's feasibility during clinical trials, and the manufacturing and commercialization of the drug. The agreement also included a termination provision which permitted Forward to terminate the agreement by written notice, which would become effective 60 days after notice was received.

During the year, Forward began negotiating a preexisting intellectual property dispute with another pharmaceutical company, Biogen. According to Ixchel, Forward apparently disclosed a copy of the Collaboration Agreement to Biogen without Ixchel's consent, which revealed information about the parties' efforts to develop the new neurological drug. Because Biogen allegedly viewed that potential new drug as a threat to its own multiple sclerosis drug, Biogen purportedly directed Forward to cease its collaborative efforts with Ixchel as part of the settlement of the parties' IP dispute. When the settlement was ultimately executed, Biogen agreed to pay Forward $1.25 billion and Forward agreed to stop working with Ixchel pursuant to an agreed-upon noncompete provision in the settlement. Pursuant to that provision, Forward subsequently provided its termination notice to Ixchel under the Collaboration Agreement, which effectively ended the parties' joint venture related to the new neurological drug.

Ixchel responded by filing suit against Biogen, asserting claims for (1) tortious interference with a contract; (2) intentional and/or negligent interference with prospective economic advantage; and (3) violations of California's unfair competition law.

District Court

The U.S. District Court for the Eastern District of California dismissed both interference claims because Ixchel had failed to allege the existence of an "independent wrongful act." Although only the "prospective economic advantage" interference claim ordinarily requires such a showing, the court explained that because the agreement was an at-will contract, Ixchel was required to make that showing in its case against Biogen as well. Since Ixchel failed to plead any such "independently wrongful acts," both claims were dismissed. The district court also dismissed Ixchel's UCL claim because Ixchel failed to allege any unlawful business practice.

Ixchel responded by amending its complaint to include allegations that the noncompete in the Forward/Biogen settlement agreement violated Section 16600 of the California Business and Professions Code. According to Ixchel, by agreeing to a provision offensive to Section 16600, an "independent wrongful act" had been committed for Ixchel's interference claims. The district court dismissed Ixchel's claims again, reasoning that Section 16600 only barred covenants not to compete between employers and employees -- not between businesses like Forward and Biogen. Ixchel appealed the dismissal to the 9th Circuit.

9th Circuit

Instead of opining on the important questions of California law presented by Ixchel's appeal, the 9th Circuit took the less common route of certifying both questions to the California Supreme Court for resolution. The 9th Circuit explained, while it was undisputed that such a showing must be made to assert an interference claim in the context of an at-will employment contract, it was not clear whether it was required in the context of at-will contracts in general, like the one between Forward and Biogen.

Observing that "[n]either the California Supreme Court, nor [the Court of Appeals], ha[d] considered whether section 16600 extends beyond the employment setting entirely to contractual restraints on business operations," the 9th Circuit abstained from answering that question as well.

California Supreme Court

As noted above, the California Supreme Court found, first, that, unlike noncompetes in employment agreements, which California courts have consistently found to be per se invalid, such provisions in business-to-business agreements are subject to the so-called "rule of reason" instead. Under that standard, courts must ask "whether an agreement harms competition more than it helps" it by considering the facts specific to the business in which the restraint is applied, the nature of the restraint and its effects, and the history of the restraint and the reasons for its adoption. Second, the court held that tortious interference with at-will contracts requires a showing of independent wrongfulness.

An Independent Wrongful Act

Regarding intentional interference with at-will contracts, the Supreme Court started by explaining the differences between interference with contractual relations claims, on the one hand, and interference with prospective economic relations claims, on the other. Whereas the latter generally require the showing of an "independent wrongful act," the former generally does not because California courts view the cementing of an economic relationship through a contract to be more worthy of protection from interference by a stranger.

However, the court explained that California courts have historically recognized an exception to this general distinction in the context of at-will employment contracts because such agreements generally do not involve the same type of cemented economic relationships as do contracts of a definite term. Because at-will employment contracts are not cemented in the way that an ordinary contract is, the court explained that California courts generally view such agreements to be more like the types of economic relationships at issue in interference with prospective economic relations claims. Accordingly, California courts will require that an "independent wrongful act" be alleged in order to state a claim for interference with an at-will employment contract.

While there undoubtedly are reasons that at-will employment agreements could be distinguished from at-will agreements in general, the court did not recognize or adopt any of them in analyzing the issue. Instead, the court held that at-will contracts between businesses should be treated the same as at-will employment contracts when viewed under the rubric of an intentional interference with contractual relations claim. Noting that a contrary holding would "risk[] chilling legitimate business competition," the court concluded by expressly mandating that an "independent wrongful act" be pleaded, not only in conjunction with interference with at-will employment contracts, but also with at-will contracts in general.

Section 16600 and the Rule of Reason

The Supreme Court pointed out that the actual question was not whether Section 16600 applied at all to noncompete provisions in business agreements (as both parties agreed that it does), but whether such provisions were per se invalid (as Ixchel argued) or whether they were subject to a reasonableness standard (as Biogen argued). While the language of Section 16600 is "broad on its face," the court explained that the statute's plain language was not necessarily dispositive. Instead, the court surveyed California's history of applying Section 16600 (and its statutory predecessor) and observed that decisional law on the statute "gradually evolved to evaluate contractual restraints on business operations and commercial dealings based on a reasonable standard," despite the more strict language of the statute.

The court recognized that California courts had "interpreted the statute more strictly" when analyzing "agreements not to compete after the termination of employment or the sale of interest in a business." Through that lens, the Supreme Court observed that, over time, California courts have generally invalidated all agreements "not to compete upon the termination of employment or upon the sale of interest in a business" without inquiring into their reasonableness. On the other hand, however, the court observed that California courts have only invalidated other contractual restraints if such restraints were unreasonable. The court distinguished noncompete provisions in those types of agreements from the Forward-Biogen agreement by noting that decisions relating to post-employment noncompetes were animated by "policy considerations specific to employment mobility and competition," which ostensibly were not implicated by ordinary restraints on trade like the one in the case at bar.

The court then turned to Section 16600's "broader statutory context" by looking to statutes arising under the adjacent Cartwright Act that contained similarly strict language, but that had nevertheless not been interpreted in the "sweeping fashion" urged by Ixchel.

Finally, the court observed that a "strict[] interpret[ation] [of] the language of Section 16600 [requiring the] invalidat[ion] [of] all contracts that limit the freedom to engage in commercial dealing" would discourage important policy goals. Specifically, the per se rule advocated by Ixchel would harm businesses' ability to "leverage complementary capabilities, ensure stability in supply or demand, and protect their research, development, and marketing efforts from being exploited by contractual partners." The procompetitive effects of such arrangements, therefore, militated in favor of adopting a rule of reason in evaluating the noncompete at issue.

Impact

The Ixchel decision will have broad impacts on the ways in which California businesses (and businesses that opt to be governed by California law) operate. By raising the threshold for adequately stating an intentional interference with an at-will contract claim, the Ixchel decision will promote enhanced and aggressive competition between California businesses. By all but blessing conduct like Biogen's (in which Biogen incentivized Forward into terminating its agreement with Ixchel), the court's decision may even blur the line between predatory economic behavior and legitimate business competition.

On the other hand, the high court's decision effectively saved legions of restraints on trades imposed through business-to-business agreements from extinction. In rejecting Ixchel's argument that such provisions are per se invalid, the court has paved a way to legitimize countless important types of contractual arrangements, ranging from exclusivity agreements between joint venturers to output agreements between producers and buyers. 